Toxic Asset Plan May Woo Investors, but Long-term Impact Is Unclear

March 23, 2009 at 6:20 PM EST

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While markets rose Monday on details of the toxic asset plan, critics voiced concern over taxpayer risk and the need for a long-term fix to financial sector troubles. New York Times columnist Paul Krugman and Donald Marron of Lightyear Capital debate the details.

JEFFREY BROWN: And we get two independent assessments now about the plan and the questions surrounding it. They come from Paul Krugman, a Nobel Prize-winning economist at Princeton University and columnist for the New York Times, And Donald Marron, CEO and founder of Lightyear Capital, a private equity firm in New York. He’s worked in the financial services industry for more than 40 years.

Well, Paul Krugman, you wrote critically of the plan this morning. Now you’ve heard Lawrence Summers. Are you persuaded?

PAUL KRUGMAN, columnist, New York Times: No. You know, I wish Larry the best; I hope he’s right. But this is a plan that treats a fairly minor symptom of the problem.

You know, that maybe some of these toxic assets — I guess they’re now toxic legacy assets, whatever — are being under-priced in the market. And maybe there’s a problem there.

But the fact of the matter is that the banks made a huge bet. They made a bet that the housing bubble was nonexistent, that, you know, historically unprecedented levels of consumer debt were not a problem. They lost that bet.

And this plan does almost nothing to rescue them from the consequences of that bad debt. So I’m kind of saddened. It’s kind of a punt. They’ve decided to sort of not really take on the critical issue of fixing the banks and instead hope that a little bit of rearranging of the financial furniture will solve the problem.

Valuing assets is difficult

Paul Krugman

The New York Times/Princeton University

Only a little bit of it is going to trickle to the really critically injured banks. So it's just not -- it's a plan that kind of mistakes the nature of the problem that we face.

JEFFREY BROWN: Well, you heard Larry Summers in our interview. He used the phrase "vicious cycles turn into virtuous circles," that this would get the banks lending again. So you just don't see that enough is done here?

PAUL KRUGMAN: It's a very poorly targeted instrument. What you have is banks that have taken huge losses. And those are real losses. They're not just because the markets aren't working so well in toxic paper.

And to get the markets, to get capital flowing, to get credit flowing to the real economy, you actually need to make the banks sound again. It would take a huge increase in these prices. It would take a tremendous -- basically, you'd have to convince people that all these bum mortgages are actually pretty good in order to make the banks secure enough to start, you know, a lot of new lending.

This is not going to do that. It's going to help a little bit, maybe. Certainly it's -- you know, basically the plan hands out gold-plated toasters to anybody who participates. It's a very sweet deal for the investors. And it's going to push up the prices, but a lot of the benefits will go to financial institutions that are actually not in any trouble. A fair bit of the benefits will go to people who are not in the financial industry at all.

Only a little bit of it is going to trickle to the really critically injured banks. So it's just not -- it's a plan that kind of mistakes the nature of the problem that we face.

JEFFREY BROWN: All right, let me bring in Donald Marron. First, I want to ask you, as a private investor yourself, is this a plan that you yourself, your company, might invest in, to start buying up some of these assets?

DONALD MARRON, Lightyear Capital: I think it is. First of all, it's about housing. Housing is the crucial element in this economy. It's what got us into the trouble; it's what we need to fix in order to get it out.

And it's not just about buying assets. It's about the fact that the housing in this form has frozen the banks. And this is the beginning of the ice breaking.

It does at least three things. First, it creates a certain amount of transparency. We'll find out what these assets are. Secondly, it will create a value for them. We'll find out what people are willing to pay for them. And, third, we'll find out who's willing to pay for them.

These three things are central to getting a market moving again. So I think it's a very smart decision in terms of a very, very complicated problem. It gets things moving. It gets smart people focused on marketability and value and learning what they are.

JEFFREY BROWN: I want to pick up on your, I think was it was B, or your second point there of your three. That was pricing the assets, because this has been a problem from the get-go here is, how much are they worth? So you think that by this kind of a plan that we'll start to see companies, private investors, competing against each other and really setting a price?

DONALD MARRON: Yes. Wall Street has been based for the last 100 years in making illiquid things liquid. What's happened in this case is formerly liquid assets have become illiquid. This process has to be restarted.

This is going to create a bundle of loans and securities. It will make visible what they are. It will have professional buyers who will look at them and make an assessment of what they're willing to pay for them. And then, in addition, of course, they're going to get a certain amount of leverage from the government. Those things are essential to restart a market.

Taxpayer bears most risk

Donald Marron

Lightyear Capital

What this project will do, it will certainly show -- it will be transparent just how bad they are, at least to some degree, depending on which of the assets the banks are willing to offer for sale. And it will find some real buyers.

JEFFREY BROWN: Well, Paul Krugman, pick up on that specifically. Will it not bring in professional investors to set prices, compete against each other, start getting things moving again?

PAUL KRUGMAN: Well, it will probably bring some in because it's offering a terrific bet. It's basically heads the investors win, tails the taxpayer loses. I mean, you're going to be able to borrow 85 percent of a purchase price, which means that at most you can lose 15 percent, whereas you might gain a lot more.

So it's a situation where investors would be willing to bid considerably more than the assets are probably worth because they get all of the upside and bear only part of the downside. So it's not actually going to be giving you what the things are really worth; it's basically bribing private investors to go out and buy the stuff.

And if I can pick up on what Donald Marron was saying there, you know, if you think that the basic problem we have is liquidity, it's just that the stuff is frozen, it won't move, and that's why we're in trouble, then this might do the trick. But, you know, I think we're long past that now.

The fact of the matter is that there were a lot of truly bum investments made, that the banks have lost enormous amounts of money for real, not because people are panicked, not because things are not transparent, but because, in fact, the banks bet heavily on the idea that housing prices at the levels of the middle of 2006 actually made sense.

And, you know, Donald Marron is assuming, a lot of people are assuming that, if we knew more, things would look better. That's not at all clear. There's a pretty reasonable chance, particularly when you compare what these assets are probably really worth with the values at which they're being carried on the books of a lot of banks, knowing more might actually make things look worse than they are, not better.

JEFFREY BROWN: Mr. Marron, go ahead. Respond.

DONALD MARRON: Well, yes, I think I have quite a response on that. I think, first of all, it isn't just about marketability. It's the fact this has happened.

Many of these assets were overpriced. There is no doubt about it. The losses are there. But that's already -- it's built in. Citibank stock got down to 99 cents at one point, and it's now $3. The market has already understood that and decided that's the case.

The bigger issue isn't that at all. It's, how do you get the banks to begin lending again?

In order to get this economy going, houses, that are the central part of not only people's economic future but their self-worth and their sense of family, are hard to buy, foreclosures, all the things that have been documented extremely well. So what's needed now is a way to get the banks going again.

What this project will do, it will certainly show -- it will be transparent just how bad they are, at least to some degree, depending on which of the assets the banks are willing to offer for sale. And it will find some real buyers. So, yes, that doesn't solve the problem at all; there's no question about it.

But it does make the problem measurable and more understandable. And it does create pools of capital available to buy new assets, to buy new loans, and this is bound to stimulate the economy and bound to stimulate lending and housing.

And if you think about this problem in the larger sense, housing is down, but new family formations of 1.5 million a year or so, as Paul Krugman knows, are generating potential opportunities. There is building demand for houses as they get lower.

The problem is, even if the houses go down in price, unless there is money there to lend to people to buy them, you're not going to solve the housing problem. This is a step in having that chain work.

'Toxic banks' are real problem

Paul Krugman

The New York Times/Princeton University

They have just punted on the key issue of fixing the -- it's really toxic banks, not toxic assets that are the problem. And this is addressing the wrong issue.

JEFFREY BROWN: What about his other key point, Mr. Marron, the key point that Paul Krugman brought up and others have, that the government, the taxpayer taking on the risk here? He used some very strong language, Mr. Krugman, that is, he said "bribing investors."

DONALD MARRON: Yes, Paul Krugman is one of the most brilliant economists that I know, and I know a lot of economists. I think in this case the answer is, it's already happened.

These banks own the thing one way or another. The government is propping them up. When you talk about nationalization of a bank, then you're going to have 100 percent of the problem.

The issue is now, how do you bring in private capital? Historically that's always been the case in this economy. It's there. There's over $4 trillion in money market funds at the moment, and much of it isn't designed to stay there, because it's in pension plans and 401(k)s. How do you bring this money into the market now? You've got to make it very attractive.

Â I hope the government has set it up that, once it gets going, they can change the terms, as the market gets more comfortable, as more confidence this thing is actually going to work, isn't as concerned about what the Congress is going to do as they are in the case of TALF.

So this is getting things going. There needs to be flexibility in the future. I'm assuming Tim Geithner and Larry Summers have thought that through. So once we get it started, we can make sure it becomes a positive continuing force and not some kind of a windfall.

PAUL KRUGMAN: I don't think that's the issue, really. I mean, there's a lot of people who've got money parked in the banks. The problem is that people -- it's the banks as institutions that are the issue, not whether people are willing to buy these particular assets.

In a way, we'd like to make the whole story of these assets go away. The only reason that they're there, the only reason it's an issue is because the banks have lost so much money that they are not effective at their job of passing funds from one end of the economy to the other.

This is not going to change that. I mean, it's going to make some of the stuff sell for a slightly better price, but the banks are still going to be deep underwater, at least the troubled ones are going to be. It's going to convey some windfall benefits to people who are holding some of this paper who are not actually crucial financial intermediaries.

I mean, there's an attractive metaphor here. It was that we've got this kind of logjam and we're going to break open the logjam by pushing a little bit of liquidity through it and everything is going to loosen up. But when you start to think that through, it doesn't really work. What we really need to do is repair the balance sheets of the troubled banks. And this doesn't do that. It's just going to provide a little bit of help at fairly considerable taxpayer expense.

They have just punted on the key issue of fixing the -- it's really toxic banks, not toxic assets that are the problem. And this is addressing the wrong issue.

Increasing capital is key

Donald Marron

Lightyear Capital

We don't exactly know what these things are. Just knowing is going to be a help, getting it out in the marketplace. The marketplace will be able then to size it and appreciate it in a more specific way.

JEFFREY BROWN: Let me ask -- I'm sorry, let me ask Donald Marron one more last thing, just on that, because we did see this big jump in the stock market today. You're the one here who thinks very positive things can come out of this. How do we know? Or when exactly do we know? How do we measure when this is working?

DONALD MARRON: Yes. First, we obviously don't know. I think we measure when it's working based on the three things I said.

First, we've got to see what these assets are finally. We've heard that they're toxic. We know in the market some of them sold at low prices. We don't exactly know what these things are. Just knowing is going to be a help, getting it out in the marketplace. The marketplace will be able then to size it and appreciate it in a more specific way.

JEFFREY BROWN: All right. All right.

DONALD MARRON: The second thing is more capital. More capital begets better opportunities. You can make the banks work. It's a very hard job. I agree with him.

JEFFREY BROWN: All right. I've got to stop you there. Donald Marron and Paul Krugman, thank you both very much.

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